Tax Rates Are Going Up—Are You Ready?

Some big changes to federal income tax rates went into effect this year. Investors, small-business owners, and high-earners could have a rude jolt when they file 2013 tax returns, so we’d like to explain the changes and suggest some steps you could take to minimize the burden.

Here’s a look at the changes in 2013 tax rates that we think will have the greatest effect on our clients and friends:

The federal rate for long-term capital gainshas gone up from 15% to 20% for a single person with taxable income above $400,000 or a married couple with income above $450,000. People in a 25% or 35% tax bracket will continue to pay 15%, while those in a 10% or 15% bracket do not have to pay capital gains taxes.

– Long-term capital gains continue to be taxed as ordinary income in California.

The top federal income tax rate for 2013 is 39.6%, up from 35% for 2012. This rate kicks in for all taxable income above $450,000 for a couple filing jointly, or $400,000 for a single filer (income below those amounts is taxed at lower rates).

– If you file taxes in California, you’ll pay up to 12.3%, as before, unless you’re single and earn more than $1 million or married filing jointly and earn more than $2 million. Taxable income above those limits is taxed at 13.3%, which includes a new 1% mental health tax.

Qualified dividends (from qualified stocks you’ve owned for 12 months or more) will be taxed like long-term capital gains in 2013. Thus, taxpayers in the 10% or 15% tax brackets will not pay taxes on them and taxpayers in the 25% or 35% tax brackets will continue to pay 15%. Taxpayers in the 39.6% tax bracket, however, will pay 20% plus the 3.8% Medicare surtax described below.

For 2013, employees must againpay 6.2% as their contribution to Social Security. (In 2011 and 2012, employees had to pay only 4.2%, a benefit of a short-term federal stimulus plan.)

Medicare surtaxes have gone into effect for 2013 that will affect you if you’re a high earner, have investment income, or own a small business.

– You’ll have to pay 0.9% more in Medicare taxes on earned income of more than $200,000 if you file as a single, or $250,000 if you’re married and file jointly.

– At the same income levels ($200,000 single, $250,000 married filing jointly), you’ll have to pay an additional Medicare tax of 3.8% on your investment income. Investment income includes interest, dividends, royalties, and passive-activity income (e.g., rental income, limited partnerships).

– Small-business income that is classified as “income, gain or loss on working capital” is also subject to the Medicare surtax, which is not deductible through self-employment.

Strategies that might reduce your tax burden as an individual

Tax-loss harvesting is most effective as part of a year-round program, but you should still be able to get some value from the strategy in the fourth quarter. Basically, what you do is to sell stocks in a taxable account that have lost value and use those losses to offset gains elsewhere in your taxable portfolio. If your long-term losses are greater than your long-term gains, they can be applied to your short-term gains. Similarly, if your short-term losses are greater than your short-term gains, they can be used to offset long-term gains. And they can offset up to $3,000 a year of ordinary income. Please see our recent blog about tax-loss harvesting.

Other ways that you can reduce your taxable income include making the maximum allowable contributions to 401(k)s, IRAs, and health savings accounts (HSAs).

Charitable contributions (cash or noncash) not only reduce income but also are a way to avoid the alternative minimum tax (AMT). The amount donated to charities is not counted in income for AMT purposes.

Donating appreciated securities to qualified charitable organizations is of particular benefit to high-earners. If the securities have been held for at least one year, you may deduct the full market value of the securities from your income, allowing you to write off the charitable deduction and avoid paying capital gains tax on the appreciation.

Talk to your financial advisor about your asset location. Tax-efficient assets like municipal bonds, equity index exchange-traded funds (ETFs), and growth stocks held for the long term may make sense in a taxable account. On the other hand, tax-inefficient assets such as taxable bonds, equity mutual funds with high turnover, and real estate investment trusts (REITs) could generate taxable income; it might be better to keep them in tax-advantaged accounts such as 401(k)s, 403(b)s, 457 plans, IRAs, and tax-deferred annuities.

Interest from municipal bonds is generally exempt from federal taxes, and if the bonds were issued by the state in which you live, it’s typically exempt from state income taxes as well.

If you can afford it, delay collecting Social Security. This reduces your taxable income, and your benefit amount will generally continue to grow during the period between your full retirement age and age 70.

One easy step to reduce the amount of taxes you’ll owe is to maximize your business deductions in 2013. Consider prepaying upcoming expenses if you think your business income will be higher in 2013 than in 2014.

Sole proprietors should consider setting up one or more of these plans: defined benefit, 401(k), or profit-sharing. Providing benefits like these helps you attract and retain valuable employees as well as giving you a way to accumulate assets for your eventual retirement. You might want to review our recent discussions about defined benefit plans and 401(k) plans.

If you’re a small-business owner and operate as a sole proprietor, you have to pay self-employment taxes of 15.3% on your income. If your business earns enough, you’ll also be facing the new 3.8% surtax. You may want to speak with your tax advisor about reorganizing as an S corporation or another type of entity with more favorable tax treatment. As an S corporation, your business would not pay self-employment taxes. Instead, the business would pay you a salary and you’d pay self-employment taxes only on your salary. The remainder of the business’s income would be considered dividends, which aren’t subject to Social Security taxes. Another advantage of restructuring as an S corporation or other entity is reducing personal liability, but there are also drawbacks that you should discuss with your tax advisor.

Whether you pay taxes as an individual, a couple, or a business, planning ahead and drawing on the knowledge of your financial professionals can increase the amount of hard-earned money that you’re allowed to keep.

We want to thank Manuel Gonzalez, EA, of MCC Financial Services Inc. for his invaluable input. If you have any questions, please call us at (925) 365-1533, or send an e-mail to lifeplan@accretivewealth.com.

Accretive Wealth Management is not a tax firm or a certified public accountant and cannot offer tax advice. Please consult your tax advisor. If you don’t have one, we can recommend one to you.